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Debt dilution and sovereign default risk

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  • Juan Carlos Hatchondo
  • Leonardo Martinez

Abstract

We measure the effects of debt dilution on sovereign default risk and show how these effects can be mitigated with debt contracts promising borrowing-contingent payments. First, we calibrate a baseline model à la Eaton and Gersovitz (1981) to match features of the data. In this model, bonds' values can be diluted. Second, we present a model in which sovereign bonds contain a covenant promising that after each time the government borrows it pays to the holder of each bond issued in previous periods the difference between the bond market price that would have been observed absent current-period borrowing and the observed market price. This covenant eliminates debt dilution by making the value of each bond independent from future borrowing decisions. We quantify the effects of dilution by comparing the simulations of the model with and without borrowing-contingent payments. We find that dilution accounts for 84% of the default risk in the baseline economy. Similar default risk reductions can be obtained with borrowing-contingent payments that depend only on the bond market price. Using borrowing-contingent payments is welfare enhancing because it reduces the frequency of default episodes.

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Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 10-08.

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Date of creation: 2012
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Handle: RePEc:fip:fedrwp:10-08

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Keywords: Business cycles ; Financial institutions ; Financial markets;

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Cited by:
  1. Juan Carlos Hatchondo & Leonardo Martinez, 2013. "Sudden stops, time inconsistency, and the duration of sovereign debt," Working Paper 13-08, Federal Reserve Bank of Richmond.
  2. repec:fip:fedreq:y:2012:i:2q:p:139-157:n:vol.98no.2 is not listed on IDEAS
  3. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "On the benefits of GDP-indexed government debt: lessons from a model of sovereign defaults," Economic Quarterly, Federal Reserve Bank of Richmond, issue 2Q, pages 139-157.
  4. Juan Carlos Hatchondo & Leonardo Martinez & Cesar Sosa Padilla, 2013. "Voluntary Sovereign Debt Exchanges," Department of Economics Working Papers 2013-13, McMaster University.
  5. Satyajit Chatterjee & Burcu Eyigungor, 2013. "Debt Dilution and Seniority in a Model of Defaultable Sovereign Debt," 2013 Meeting Papers 654, Society for Economic Dynamics.
  6. Juan Carlos Hatchondo & Leonardo Martinez & Francisco Roch, 2012. "Fiscal rules and the sovereign default premium," Working Paper 12-01, Federal Reserve Bank of Richmond.
  7. Sosa-Padilla, Cesar, 2012. "Sovereign Defaults and Banking Crises," MPRA Paper 41074, University Library of Munich, Germany.
  8. Gonçalves, Carlos Eduardo & Guimarães, Bernardo, 2012. "Sovereign default risk and commitment for fiscal adjustment," CEPR Discussion Papers 9163, C.E.P.R. Discussion Papers.
  9. John Hatfield & Fuhito Kojima & Yusuke Narita, 2012. "Many-to-Many Matching with Max-Min Preferences," Discussion Papers 12-020, Stanford Institute for Economic Policy Research.
  10. Minetti, Raoul & Peng, Tao, 2013. "Lending constraints, real estate prices and business cycles in emerging economies," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2397-2416.
  11. Demian Pouzo & Ignacio Presno, 2012. "Sovereign default risk and uncertainty premia," Working Papers 12-11, Federal Reserve Bank of Boston.

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